How Should Investors Forecast Earnings Growth?
Once you’ve decided that a company has grown its sales and earnings at acceptable rates, you need to determine if it can sustain that growth over the next five years. In most cases, it is prudent to expect a somewhat lower rate of growth than the company has experienced in the past.
When projecting future growth rates, you should keep in mind that
- Rates of growth for any company typically decline over time
- Growth rates differ by industry and by size of company.
- Earnings cannot grow faster than revenues over time.
Most companies are doing very well if they can increase sales and earnings at a rate of 15 percent over the long term.
Here are some questions you should ask about a company’s past growth that will help you project the company’s future growth prospects.
- What is the company’s sales growth rate over the past five to ten years?
- What is the company’s earnings growth rate over the past five to ten years?
- Have sales and earnings been increasing steadily?
- How do these growth rates compare with other companies of the same size and in the same industry group?
- Are there any years in which sales and/or earnings declined? If so, were they one time problems, or cyclical changes, or indications of potential fundamental changes in the company’s business?
- Have earnings been increasing at about the same rate as sales, and not faster?
- Does the company have the potential of providing sufficient growth of both sales and earnings in the future to meet your goals?
- Finally, what is your assessment of future sales and earnings growth?
These questions are just like the ones that professional analysts ask when they examine a stock. If you can project how fast a company is likely to grow its sales and earnings in the future, you can then move on to determine the potential return you might receive on your investment if the company can meet that goal.
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